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Chapter 6 Interest Rates and Bond ValuationWhat is the real rate of interest? Can this rate be controlled?Base rate created by supply and demandExtremely low now (.3 to .5%)What is the risk free rate? Can we find this interest rate?Rate on treasury securitiesReal rate + inflationYahoo finance to find current ratesThe government offers I-Bonds. These bonds are identical to the usual government bonds, except that they are inflation adjusted.What does inflation adjusted mean?The value of the security and the cash flows keep pace with inflationIs this good or bad?What is the relation between the returns of the US Treasury Bond and the I-Bond?I bond has lower returnsWhy?What is the relationship between the prices?I bonds have higher pricesWhat is the Term Structure of Interest Rates?A table of the yields of treasury securities and their maturities.A yield curve is a picture of this.What is the relationship between the stock market and the bond market? relationshipStock price up bond prices downStock returns down bind returns upHow can you explain the two theories of how the yield curve is created?Expectations TheoryInterest rates are created by the expectations of investors about future rates and inflation.The curve reflects expected future inflation. An upward sloping curve implies inflation increasing.Liquidity Preference TheoryTo get people to invest long term you must pay them.The real rate of interest is 2.45%. The inflation premium is 3.13%. What is the approximate nominal rate? 1552575114427000What is the Fisher Effect nominal rate?This is the risk free rate based on economic theory. Only appropriate for Treasury securities.Are these equal? Why or why not?NOFisher effect is theoretical; only reflects treasury securitiesApproximation is not mathematically correct (no time value)Reflects risky assetsCan you describe a corporate bond? What are its characteristics?Interest only debtFixed coupon; $1000 principalTypically pays interest semi-annuallyHow do the following factors impact interest rates? Prices of Bonds?Length to maturitythe size of the offeringthe default risk of the issuing firmthe cost of money in the capital market longer ; higherlarger ; higherhigher; higherhigher ; higherprice the oppositeHow does this table reflect risk? What is true in general about the prices of differently rated bonds?127000020193000The higher in the table the lower the risk; lower chance of defaultHigher pricesBasic Valuation Model48260026416000Let’s review the basic investment rulesIf Value >= Price, buy the assetPrice is known, so we must solve for valueWhat happens if CCF, risesWhat happens if r increasesWhat is rIf Expected return >= required return, buy the assetExpected return = return if we buy at the current price and the cash flows actually occurRequired return reflects risk, inflation, and real rates of returnYou can buy a 30 year zero coupon bond with a required return of 8%. What is the value of this bond?82867513017500 A bond is selling for $900. It has a coupon of 3.5% and a maturity of 20 years. This bond has a S&P rating of AA. What is the value of the bond? If you purchased this bond, what would the YTM be?8763008636000 What causes bond prices to change over time? Interest rates (market risk)Risk of the company (company risk)timeWhat is a Bond? This might clear up some questions!! Final analysis let’s discuss the following questions:If you buy a bond today for $900 that matures in 20 years, what will its value be in 10 years?93345013906500When it matures in 20 years, what is its value?When you by a bond, how do you make money?Interest paid semi-annuallyReceive $1,00 when it maturesWhat is the chance that you will not get these?Bond ExamplesWhat is the value of a 15 year, 5% coupon bond with a required return of 8%?60960020193000What is the value of a 15 year, 10% coupon bond with a required return of 8%?55245020193000If you bought the bond in (a) for its value, what is your YTM? Would you buy this bond?89408018605500If you bought the bond in (b) for its value, what is your YTM? Would you buy it?89535015938500Describe the return earned on bond (a)? bond (b)?Both return 8%How the return comes is differentWhich will the investor want if the risks are equal?How can you reconcile this?Discuss different types of investors.Wealthy retiredHomework (39 points) ______ Research (22 points) ________Chapter 6 Homework assignment (Problems are from the textbook.)The current interest rate for a 5 year Treasury note is .75%. IF the current inflation rate is .1% what is the real rate. .65%The current rate on a 30 year Treasury bond is 3.2%. If the real rate is approximately 2%, what is the inflation rate.1.2%If a corporate AAA rated bond yields 5.6%, what is the risk premium given the 30 year treasury rate in question 2?2.4%Valuation (time value worksheets) (6)Cash flowDiscount rateValue0 2000 2000 200010%497301 250 2 350 3 450 4 7508%144001 – 19 020 2,7507.75%618Business finance / bond valuation (5) Bond Valuation spreadsheetBondMaturityCouponRequired returnValueA1057859B256.54.51296C303.755807D951.758219E10006.51.84Complete the following table: (5)BondMaturityCouponPriceYTMA125$9875.15%B206.5$1,0166.36%C153.75$1,0003.75%D401.75$3785.76%E1000$1761.75%The following are 2 points each (14)What is the nominal rate of return if the real rate is 3%, the inflation premium is 6%, and the risk premium is 0??9%What type of asset is in question 7?Risk freeA corporation is issuing a AA rated bond. The average return for a AA bond is 7%. The coupon rate is 9% with a 25 year maturity. What is the value of this bond?1233If you can buy the bond in question 9 now at 1100, what would your YTM be?8.06If the company issuing the bond in question 9 undergoes some bad times and in 5 years the rating drops to BB, what will the value be in 5 years if the yield on BB bonds at that time is 10%?914If you waited and then purchased the above bond in 5 years for 850, what would your YTM be then?10.87The bond in question 9 is callable in 10 years. The price is currently $1,100. If the call premium is the par value and one years interest what is the yield to call?8.12Chap 6 Web Exercise Go to / investors / market dataFor company data input your company’s ticker symbolDoes your company have bonds? If not, choose one of its competitors.Click on the hyperlink to see “more bond information”How many bonds are listed? (1)Complete the next tasks. Click on the bonds hyperlink to find the number of bonds outstanding.Highest couponmaturityCallableYes / noRating S&PPriceYieldOutstanding bondsSort by couponSort by maturitySort by priceSort by yieldGo back to (click on the todays market/ composite bond rates What are the yields on the following issues? (9pts)Treasury Yields3 month5 year30 yearMunicipal AAA5 year10 year20 yearMunicipal A5 year10 year20 yearCorporate AAA5 year10 year20 yearCorporate A5 year10 year20 year ................
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